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The Entrepreneurial Path is measured in terms of the time it takes to achieve a certain level of profitability. Profit allows a business to cover expenses, pay investors, repay debts, reward key contributors, and invest to achieve future growth or attract a buyer if acquisition is the goal. The sooner a company reaches profitability the better.

Starting out, most companies are not profitable. In fact, many startups go through a period of significant capital losses or negative profitability. Until the company can raise money through revenue, it must find other sources of capital. Outside investment is achieved by targeting the right sources of capital at the right stage of business growth.

One of the most common misconceptions by entrepreneurs is that they must raise a great deal of capital up front to succeed. This is simply not true. There are many, many entrepreneurs–especially in the years before and after the dotcom bubble–who started with very little capital investment.

Companies such as Cisco, Oracle, Microsoft, Mary Kay Cosmetics, and UPS are modern era business success stories that started with relatively modest amounts of up-front investment.

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Stanford professors Leonard Bosack and Sandy Lerner had a need to e-mail each other but could not because each had non-compatible systems. After achieving proof-of-concept, they developed a router to accomplish their need. This husband and wife team went on to start Cisco in 1984 to commercialize their innovation. Funded through credit cards and revenue growth, Cisco was profitable with over $2.5 million in annual revenue before receiving venture capital from Sequoia Capital in 1987. Turns out, they never spent it!

There are plenty of other companies that started with less than $10,000: Apple Computer, Dell Computer, Gateway, Papa John’s Pizza, and Ernst and Julio Gallo, to name only a few.

This isn’t to minimize an entrepreneur’s need to focus on capital. It just emphasizes that there are lots of ways for creative and focused entrepreneurs to move their ideas along the path from bright idea to prototype without having to raise bundles of capital.

And that’s a good thing, because raising large amounts of capital in the beginning stages of the Entrepreneurial Path is very difficult and can consume far too much of the entrepreneur’s time.

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dEvELoPinG a CaPiTaL PLan

Founders, Friends, and Family Customers/Strategic ~ Banks ~ Grants ~ Bootstrap

Angel Investment ~Venture Capital ~ IPO

Developing a capital strategy and plan based on focusing on the correct capital source and identifying achievable milestones that follow the flow of the Entrepreneurial Path can simplify the capital raising process.

Take a moment to review the chart in Chapter 1.

Traversing the capital path is not usually accomplished in such a straightforward fashion as is presented in this graph. The principles are the same for each business, but from one company to the next the experience is different.

Some companies may accelerate through certain stages; other companies may move forward and then step backward before they move forward again. And still other

Chart 3.1The Capital Path

PROOF-OF-CONCEPT

GROWTH

MATURITY

EARLY

BREAK EVEN

SEED

START-UP

Banks, Equity Markets

PRofIt

TIME

Valley of death

PR

OFI

T

Founders, Friends, Family, & “Fools”

Angels, Grants, Bootstrap

Venture Capital

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companies falter before they can raise or earn enough capital to succeed.

CaPiTaL MarkET-SPEakTo move along the path of developing an investment strategy, you first have to learn and understand the language of the capital markets.

Angel investor: An angel investor is a wealthy individual who provides capital for a startup business in return for ownership shares in the business or convertible debt. Angels often organize into angel groups or angel networks to share deal flow, due diligence on potential investment companies, and to pool their investment capital.

Convertible debt: Some investors and banks will offer capital under terms of convertible debt. In these borrowing arrangements, the lender has the option to convert the debt into shares of equity at a specified point in time.

Dry powder: Savvy investors often hold back a portion of investment capital in anticipation of unexpected events.

Equity Investment: Investments made in return for a percentage ownership in the company, which usually takes the form of common or preferred shares of stock.

First Round, Second Round: This ordinal nomenclature is used to describe most venture rounds. Companies will casually call their rounds first, second, third, etc. even though the legal term for the transaction as stated in

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closing documents and amendments to the documents of incorporation may refer to them as Series A preferred, Series B common, etc.

Grants: Grants come from businesses, foundations, and public and private sector organizations. Some grants require the entrepreneur to come up with matching funds from other sources. Unlike loans or equity capital from investors, grants do not have to be repaid.

Initial Public Offering: IPO stands for initial public offering and occurs when a company first sells shares of its stock to the public.

Mezzanine: A mezzanine equity investment round is generally characterized as the last venture round prior to an IPO or some other positive exit event.

Portfolio: Collection of investments made by angels or venture capitalists.

Syndication: Multiple investors, which may include individual angels, angel groups, and venture capitalists, pool their funds to provide larger investments and to diversify risk.

Third, Fourth, Fifth, etc. and Later Rounds: Equity rounds that fall after the second round of financing.

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Valuation: Valuation reflects the value of the company before and after the investment of additional equity capital. Establishing the value of a pre-revenue company is challenging and can be an impediment to entrepreneurs raising capital.

Venture Capital: Venture Capital is pooled investment capital from institutional investors and high net worth individuals. Because of the size of VC funds and operating costs, most VC funds find it more efficient to invest $2 million or more. This means they are more likely to seek out high growth technology businesses that are producing revenue with the exception of life sciences.

The investor drives the capital raising process. Always. The entrepreneur must identify and implement realistic milestones to attract investors at each stage of the Entrepreneurial Path.

STaGES of CaPiTaLWe are now ready to discuss in more detail the source of capital that are associated with each stage of the Entrepreneurial Path.

Proof-of-Concept Stage: Founders, Friends, Family, and “Fools”There is an old saying among seasoned entrepreneurs: “Starting a business usually takes twice as long and costs twice as much as you think it will.” It often makes sense to keep your day job and pursue your entrepreneurial ideas after hours in

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the beginning. Before you take out a home equity loan, max out your credit cards, or tap into your 401(k), achieve some positive progress toward the Proof-of-Concept Stage.

Recognize that sooner or later, if you decide to keep going, you are going to have to take personal financial risk. Anticipate needing between $25,000 and $100,000 to carry your business idea through the Proof-of-Concept Stage. Several million dollars will be needed if the company is in the life sciences industries.

Financing for the Proof-of-Concept Stage primarily comes from the founder’s personal resources and sometimes from friends, family, and so-called “fools.” Family, friends, and acquaintances will often invest very early in the company’s life as their trust and interest is in the individual than in the possibility of significant monetary returns.

Many entrepreneurs approach friends and family members (in some entrepreneurial circles known as the “Three Fs”–friends, family, and fools). People who know, trust, and like you may be more willing to invest, may accept a lower return on their investment with less collateral (possibly none) than a bank, and may be less likely to examine every detail of your business plan.

That’s all well and good. Just be aware that raising money from people you know may also create personal and emotional issues that add to the already heavy stress of founding a business. This isn’t to say you shouldn’t go this route. Just apply the same good business practices and arms-length relationship to this financial arrangement as you would to any other.

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Generally, you will want to have an attorney prepare the appropriate legal documents. Consider structuring friends and family money as debt (with an at-market interest rate) instead of equity. Debt holders can’t tell you how to run your business like equity partners can.

Pay off the debt as quickly as you can. Most angel investors and venture capitalists do not want their deals burdened with commitments from earlier rounds. Due to this and depending on the amount of capital needed at this stage, often times a convertible debt to equity instrument is constructed.

Sometimes entrepreneurs raise friends and family money in exchange for shares of the company. Angel investors are far less likely to invest if they have to deal with lots of small shareholders from prior friends and family rounds. Venture capitalists are even more opposed to it. Be smart and discriminating when attracting capital.

Seed Stage: Founder, Friends and Family, Grants, Banks, and Angel InvestorsOnce the feasibility of the product or service is reasonably proven, entrepreneurs need additional outside capital to take their idea from concept to a product or service that someone will buy.

Whether economic times are flush or challenging, your goal as an entrepreneur progress from Proof-of-Concept into Seed Stage must be to find creative ways to move your business forward while making 18 months of cash last for 24.

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From Proof-of-Concept through Seed Stage, expenses accelerate. The company is in product development mode, and there are no revenues. There is a reason that seasoned entrepreneurs and startup investors sometimes call this stage “the Valley of Death.”

Grants: SBIR and STTR AwardsThe federal government’s Small Business Innovation Research (SBIR) and Small Business Technology Transfer (STTR) programs can be excellent sources of early capital if the Seed Stage company meets the criteria of the award.

The government provides grants to supplement the limited research and development funding that is available to companies from the private sector.

Additionally, many federal agencies, particularly the Department of Defense, are looking for technologies and products that meet government needs and have commercial applications. Agency SBIR and STTR programs have provided critical, early capital to numerous entrepreneurs.

All federal agencies with an extramural research and development budget of more than $100 million (SBIR) or $1 billion (STTR) must participate in these programs, making them the largest source of early research and development funding for small businesses in the US. Eleven departments participate in the SBIR program and five departments participate in the STTR program. Together they award more than $2 billion to small high-tech businesses annually.

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SBIR and STTR grants are very competitive. Still, every advanced technology entrepreneur should know enough about these programs to determine whether or not the company should consider federal grants. When a company’s objectives and capabilities match the requirements of the granting agency, these funds can provide significant off-balance sheet funding.

Scientists and inventors from research and development or university backgrounds who are familiar with grant applications and reporting find SBIRs and STTRs a good option. Entrepreneurs who are founding companies to invent a drug or commercialize a nanotechnology application may also identify seeking SBIR or STTR grants as a Seed stage priority.

The grants, which provide financial assistance to companies to execute a certain scope of work, can vary from agency to agency. They cover a range of activities including research and development, testing, evaluation, demonstration, and may even include full-scale commercialization. The scope of work can be tightly or somewhat loosely defined. The company receiving the grant does not guarantee an outcome.

Generally Phase I grants award between $100,000 and $150,000 for activities of about a year or less in duration. Phase II grants are up to $750,000 for typically up to two years. Phase III projects encompass non-SBIR/STTR funding and derive from, extend, or logically conclude efforts performed under prior SBIR contracts.

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The recipients of SBIR/STTR grants are required to report progress against the scope of work with a final report at the end of the grant. As long as effort is applied in good faith, there isn’t the requirement to meet certain objectives. There is no requirement for the company to return the grant money if project objectives are not achieved.

SBIRs and STTRs are not appropriate for every company. It can be time consuming, especially for a startup company with limited human resources, to apply for an SBIR or STTR grant. It is not a good idea for an entrepreneur to count on a federal grant as the make-or-break funding for Seed Stage activities–especially if that entrepreneur has no prior experience applying for federal grants. The lengthy lead time for grant approval can also be a significant issue for entrepreneurs who need capital in a certain timeframe.

Federal agencies are always looking for advances in technology; they aren’t looking for incremental improvements. They want groundbreaking leaps that are faster, less costly, and better than alternatives–and there are always alternatives.

In addition to SBIRs and STTRs, there are other requests for proposals (sometimes called solicitations or RFPs) and agency announcements that may be for a specific technology or encompass multiple technologies and may be for a specific time frame or open to response for years.

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These opportunities are posted online by the requesting agency. Savvy entrepreneurs use the Internet to figure out which government agencies and departments might be interested in their solution or technology. It is possible to develop relationships with the program managers who follow technologies like yours. Their areas of interest and requirements are public information.

If you determine that you want to reply to an open SBIR or STTR grant or for some other government request for proposal, you may want to consider seeking the advice and assistance of someone who has been successful at the process previously. This could be another entrepreneur, a trusted mentor in a university or research institution, or a professional grant consultant. Once a company has obtained one grant with an agency, there is often the opportunity to pursue more opportunities.

When an entrepreneur learns how to develop an effective grant proposal for the federal government, that knowledge is applicable to other types of grants.

Bank Lines of Credit and Convertible NotesLocal banks, and to some extent national ones, may be a source of lines of credit and traditional debt. Some institutions and angel investors employ convertible notes, which are loans that are convertible to equity at the option of the lender or when certain events occur, such as a subsequent investment round.

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As with any loans made to a Seed Stage company, expect a convertible note to carry an above-market interest rate in consideration of your company’s risk. Depending on the terms of the loan or convertible notes, if a company lacks the cash flow to make periodic payments, there may be provisions for the interest to accrue for a period of time or until the next funding event.

Angel InvestorsAngel investors are accredited investors (think high net worth individuals who are millionaires plus) who put their own money and time into companies that are at the seed stage and beyond.

Angels invest in Seed, Startup, and Early Stage opportunities. Their and any equity investor’s approach at this stage is to provide a nominal amount of capital to see how the company progresses.

A challenge for entrepreneurs is that even though angel investors do provide about 90 percent of the outside equity that funds the initial stages of entrepreneurial businesses, individual angel investors are almost impossible for entrepreneurs to identify and reach. Angels tend to protect their privacy.

The Angel Capital Association (ACA), the trade organization of North American angel investors posts a member group directory (www. angelcapitalassociation.com). Some angel groups have websites that define their investment strategy and offer a process for business plan submission.

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The Angel Capital Association (ACA) is a professional alliance of more than 165 organized angel group members representing about 7,000 accredited investors. These angel groups fund hundreds of companies a year and have an ongoing portfolio of 5,000 companies across the US and Canada.

ACA member groups report averaging about six investments per year in between three and four companies, averaging about $200,000 per investment round.

If as an entrepreneur, you think of angel investors as flinty-eyed wealthy individuals who are out to “steal” your company, readjust your thinking. Besides being about the only source of Seed and Startup Stage capital around, angel investors know how to help coachable entrepreneurs succeed. Remember, many angels became wealthy by being successful entrepreneurs themselves.

Angels are investing to make a high rate of return given the riskiness of the investments they make. Return on investment is the primary measure of their success but not the only reason that angels invest. Many angel investors made their money as entrepreneurs. They enjoy the challenge and the risk of the entrepreneurial environment and like mentoring and advising entrepreneurs. Many angels also are motivated to give back to their communities by helping promising new companies start up.

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Angels invest independently, alongside other investors, or as members of organized angel groups. Organized angel groups have proliferated since the late 1990s; there are now groups in almost every state. They serve as a catalyst for Seed and Startup Stage investing.

Angels and angel groups are as unique and different as are entrepreneurs and startup companies. But whether from Silicon Valley or Oklahoma, angel investors are almost always looking for the same thing–a passionate entrepreneur with an idea that solves a big problem for a big market and a five to 30X return on their investment within three to five years, depending on the company’s stage of growth and its prior capital investments.

With so little venture capital money being invested in pre-revenue businesses, entrepreneurs need angel investors more today than ever before–for their money, their contacts, their expertise and experience, and their mentoring. That’s why it is very important for every entrepreneur to understand what motivates angels, how they like to receive information, what information they want to receive, and how to work with them effectively.

Some angel groups are organized as networks, which each member makes individual decisions on potential investments. Other groups are organized as funds which operate similar to other investment funds.

SeedStep Angels is an Oklahoma angel group of accredited angel investors that provide capital, strategic advice, and

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mentoring to emerging growth companies to help them achieve market leadership. Typical investments range from $50,000 to $500,000 as a group with individuals having options for side-by-side investments.

Regardless of their investment model, angels usually invest fairly close to home. They are involved with their portfolio companies and prefer to be within a two or three hour drive of their investments. Group members determine the industries where they want to invest. Life sciences, medical devices, information technology, and software are the industries that interest many angel groups.

Angels like to co-invest with other angels, angel groups, and sometimes with venture capitalists. These syndicated rounds offer efficiencies for both the investors and entrepreneurs. It is common for one group of the investors to take the lead, structure the deal terms; perform due diligence, and handle the closing.

Syndication creates larger investment rounds than any single angel or group would raise. Investors benefit from additional quality deal flow and from having extra hands, eyes, and expertise for due diligence. Additional investors provide additional validation of a good investment opportunity. Larger rounds also allow angels to keep some dry powder for unanticipated events.

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For the entrepreneur, syndicated rounds may mean that less time is required to raise more money. Raising capital takes the entrepreneur away from building a product and gaining customers. It is to everyone’s advantage, especially the entrepreneur, to hold this process to a minimum.

Interestingly, Angel Capital Association members report that in about 60 percent of their deals, they co-invest with venture capitalists.

The ACA directory is a good place to begin the search for angel investors in your geography, but the best way to make contact with angel investors is through referrals.

Startup Stage: Grants, Angel Investors, BootstrappingAt the Startup Stage it will be important to prioritize the business strategies that best fit the most appropriate financing stage and source. The company is continuing to develop the product prototype incurring significant expense with no product related revenues. The company is usually at the deepest point in the “Valley of Death” at this stage. Business strategies could include licensing, strategic alliances or partnerships, or the pursuit of a business venture.

The Start up requires sufficient startup capital to initiate business operations. The prototype provides the basis for final analysis of technical feasibility, cost, and market acceptance.

BootstrappingBootstrapping–paying as you go with revenue instead of debt or equity capital–stretches your company’s resources

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– both financial and otherwise – to fund your Seed Stage growth. Bootstrapping can be one of the most cost effective ways to hasten your company’s positive cash flow, reducing the business’s requirement for equity capital or debt.

From day one, make effective cash management a priority. The survival of your young company is determined as much by the way you prioritize the use of scarce resources–and nothing is more scarce than cash at this point except perhaps your hours of sleep–as it is by the products you create.

hold fixed costs to a minimum:• Share office services and equipment.• Co-locate with another company or move

to a business incubator.• Use the computers and servers you have.• Delay capital purchases.• Lease instead of purchase.• Negotiate fees and terms with all service providers

treat variable costs like you are spending your own money–which you are:• Seek trade credit terms with key suppliers.• Save thousands on travel by smart

scheduling and use of the Internet, or don’t travel at all.

• Speak to your local business school about internships.

And by the way, these tips for bootstrapping are excellent habits to practice whether you are bootstrapping or not.

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Early Stage: Venture CapitalThese days, venture capitalists are institutional investors with a typical investment threshold of at least $2 million in exchange for equity in early and later stage businesses. Their economic model usually does not support investment in pre-revenue stage companies. VCs look for entrepreneurs who have a track record of startup success.

In your region, it is common to find smaller venture capital funds of around $5 to $20 million. Funds in this range, may make smaller investments. However, their investment process and investment terms are similar to larger VC funds.

Similar to angels, venture capitalists seek a return potential of over ten times their investment in about five years. Like angel investors, VCs like to syndicate. However, there are also venture capital funds that do not syndicate.

To create enough upside opportunity to justify their effort and resources, VCs need to invest $3 to $5 million or more per deal. This means that VCs usually look for companies that are further along the growth curve and generating revenues from customer sales. Venture capitalists will want to speak with existing customers as part of their due diligence.

Growth Stage through Maturity: Initial Public OfferingThe first sale of your stock as a private company to the public is called an Initial Public Offering (IPO).

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An IPO raises cash and creates other benefits for the company. A public company can always issue more stock, although there is no guarantee there will be buyers. If there are, those shares will raise more cash.

Going public requires the company to strictly conform to rules of the Securities and Exchange Commission (SEC), which extensive financial reporting, the creation of a board of directors, and other regulations.

We cannot over-emphasize that IPOs are few and far between. That’s why we don’t invest much time on them. If you want more information on IPOs, use the Internet. Keep in mind, less than 20% of all venture-backed companies have IPOs.

Manage cashNo matter how successful you are at raising capital, sooner or later, your new company will be cash strapped. Regardless of your stage of entrepreneurial development, become really smart about managing cash. If capital is required, do not delay.

• Consider bootstrapping or friends and family first.

• Build a relationship with local banks.• Micro-lenders will loan from $5,000 to

$50,000.• Be prepared to provide extensive

information to prove credit-worthiness.• Stay alert for federal or state tax credits

or stimulus incentives for startup or high technology businesses.

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ConCLuSion Every entrepreneur eventually will need to raise capital to fund the milestones that lead to sustainable revenue. The process starts with understanding those milestones, then understanding the appropriate sources of capital, and then matching up the two in a well-formed business plan.

If you have a day job, keep it until you are certain your entrepreneurial idea can gain enough traction to become cash flow positive. Seek out experienced business people and entrepreneurs for advice and mentoring. Don’t allow optimism and passion to override practicality.

Carve out some time every week to de-compress. A rock-sure way for a company to fail is to have the founder suffer a heart attack.

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kEY PoinTSThe Entrepreneurial Lifecycle is measured in terms of the time it takes to achieve a certain level of profitability.

Until the company can raise money through revenue, it must find other sources of capital.

To move along the path of developing an investment strategy, you have to understand the language of the capital markets.

One of the most common misconceptions by entrepreneurs is that they must raise a great deal of capital up front to succeed.

Focusing on the correct capital source and identifying achievable milestones can simplify the capital raising process.